Project finance a win-win for government and investors
Green or social projects would be particularly attractive for those wanting a safe return on their capital
Project finance offers governments an attractive option for the financing of public infrastructure. By relying on private funding, the public sector borrowing requirement is reduced.
SA’s 2020 Budget Review projected public sector infrastructure spending over the next three years of R815bn, of which 75% is for economic infrastructure. The government’s borrowing costs have risen sharply after successive sovereign rating downgrades. An alternative approach such as project finance is not only attractive when the government’s finances are under pressure, but also serves to widen the pool of opportunities available to investors.
Furthermore, the other benefits of a well-structured infrastructure development programme include attracting foreign investment, skills and expertise, combined with the education and training of a local workforce. The government has emphasised that infrastructure is critical for economic development, and the National Planning Commission has reiterated the need for partnerships with the private sector, stating that a “clear plan” for funding and financing infrastructure would be necessary to accelerate investment.
Developing a project finance bond market in SA would rely on a steady pipeline of investable infrastructure projects, offering long-term investors a choice of assets that suit their risk/return requirements and a variety of mandates. A range of options will develop over time, but in a recent survey that included pension funds, asset managers, insurers, asset consultants and development finance institutions, investors indicated a preference for privately financed renewables.
Project finance debt can be “greenfield”, where assets are in the construction phase, or “brownfield”, where assets are operational. The credit assessment of project finance transactions is complex, reflecting the nature of the contractual relationships between multiple parties. The key focus is the identification of project and financing risks and the allocation of these risks between the contracting parties to ensure clarity on responsibilities and the associated compensation for bearing these risks. Considering the nature of such transactions, there are often clear distinctions between risks in the construction and operational stages.
The involvement of finance institutions such as multilateral development banks could stimulate the development of a project bond market. Credit enhancement could crowd-in infrastructure investments by institutional investors by using development capital alongside commercial finance to improve the risk-return profile of developments. This blended finance approach would potentially allow the extension of financing to projects that might otherwise be marginal on a purely commercial basis, but just as importantly it could provide a level of comfort for first-time investors in project bonds.
The multilateral development banks’ participation via risk mitigation tools such as subordinated “first loss” capital also enables new investors to participate more comfortably at a senior debt level. This is the approach the SA government plans to take by using the announced R100bn Infrastructure Fund partially as a viability gap fund, providing blended co-funding, capital subsidies or interest rate subsidies and guarantees to large-scale projects.
Considering the potential opportunities for infrastructure debt funding in SA, there is little doubt that debt will be placed both privately and through the listed market. With the recent amendments to the JSE debt listing requirements (section 10), enabling regulations are already in place and specify the rule for the listing of project bonds that can be offered to institutional project bond investors. Listed instruments could attract a wider pool of investors, including those whose mandates limit the purchase of unlisted debt. For investors, listed project bonds offer better price discovery mechanisms, even if the debt is not traded frequently.
The renegotiating of the funding of existing renewable energy projects offers an opportunity to refinance the transactions from previous bid windows. Since these “brownfield” projects are already operational, credit risk is lower and cash flows are predictable, making these projects ideal candidates for a listing. Such bonds will be in demand by investors whose mandates do not allow them to take construction risk. Financing the next round of renewable energy generation projects in 2021 under bid window five will allow investors with higher risk appetite to participate in the early stages of development.
In the past, the limited availability of sizeable infrastructure project finance opportunities meant concentration risk was a permanent concern for investors. Furthermore, a prudent risk management approach restricts investors’ ability to increase the size of their portfolio. In the near term, the new renewables energy purchase programme will allow for better diversification within the energy sector as the number and variety of projects increase.
However, the significant opportunity lies in the diversification of infrastructure to be funded. Public economic infrastructure in the transport, communications and water and sanitation sectors will become investable, as well as social infrastructure in the housing, health care and education sectors.
Tapping the environmental, social and governance (ESG) investment pool also offers opportunities. The substantial proportion of the infrastructure that can be financed through project bonds is likely to meet the classification criteria for sustainable debt instruments. The key feature of such bonds is that the use of proceeds is restricted to the financing or refinancing of green or social projects.
Over the past five years, the rise in “green” finance globally has been dramatic, driven by the recognition that significant investment is needed to develop resilient economies that are capable of coping with the long-term risks posed by climate change. Consequently, ESG considerations are becoming an integral part of financing decisions. In the wake of the Covid-19 pandemic, greater awareness of social factors has prompted more interest in sustainable investing.
SA’s infrastructure development drive offers opportunities to tap into a dedicated pool of both local and international capital, by structuring transactions in a way that can meet both the green and social bond classification criteria. The listing of green and social project bonds, whether for refinancing or new developments, will establish a solid foundation for the growth of this market segment.
• Ilkova is investment strategist at Rand Merchant Bank.
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